Chapter 1The Investment SettingQuestions to be answered:

• Why do individuals invest ?

• What is an investment ?

• How do we measure the rate of return on an investment ?

• How do investors measure risk related to alternative investments ?

Chapter 1The Investment Setting• What factors contribute to the rates of

return that investors require on alternative investments ?

• What macroeconomic and microeconomic factors contribute to changes in the required rate of return for individual investments and investments in general ?

Defining an InvestmentA current commitment of $ for a period of time in order to derive future payments that will compensate for:– the time the funds are committed– the expected rate of inflation– uncertainty of future flow of

funds.

Measures of Historical Rates of Return

Holding Period Return

10.1 $200

$220

Investment of Value Beginning

Investment of Value EndingHPR

1.1

Measures of Historical Rates of Return

Holding Period Yield

HPY = HPR - 1

1.10 - 1 = 0.10 = 10%

1.2

Annual Holding Period Return–Annual HPR = HPR 1/n

where n = number of years investment is held

Annual Holding Period Yield–Annual HPY = Annual HPR - 1

Measures of Historical Rates of Return

Measures of Historical Rates of Return

Arithmetic Mean1.4

yields period holding annual of sum the HPY

:whereHPY/AM

n

Measures of Historical Rates of Return

Geometric Mean1.5

n

n

HPRHPRHPR

:follows as returns period holding annual theofproduct the

:where1HPR GM

21

1

Computation of HoldingPeriod Yield for a Portfolio

# Begin Beginning Ending Ending Market Wtd.Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY

A 100,000 10$ 1,000,000$ 12$ 1,200,000$ 1.20 20% 0.05 0.010 B 200,000 20$ 4,000,000$ 21$ 4,200,000$ 1.05 5% 0.20 0.010 C 500,000 30$ 15,000,000$ 33$ 16,500,000$ 1.10 10% 0.75 0.075

Total 20,000,000$ 21,900,000$ 0.095

21,900,000$ 20,000,000$

HPY = 1.095 - 1 = 0.095

= 9.5%

HPR = = 1.095

Exhibit 1.1

Expected Rates of Return

• Risk is uncertainty that an investment will earn its expected rate of return

• Probability is the likelihood of an outcome

Expected Rates of Return

n

i 1

i

Return) (Possible Return) ofy Probabilit(

)E(R Return Expected

)R(P....))(R(P))(R[(P nn2211

))(RP(1

ii

n

i

1.6

Risk Aversion

The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return

Probability Distributions

Risk-free Investment

0.00

0.20

0.40

0.60

0.80

1.00

-5% 0% 5% 10% 15%

Exhibit 1.2

Probability Distributions

Risky Investment with 3 Possible Returns

0.00

0.20

0.40

0.60

0.80

1.00

-30% -10% 10% 30%

Exhibit 1.3

Probability Distributions

Risky investment with ten possible rates of return

0.00

0.20

0.40

0.60

0.80

1.00

-40% -20% 0% 20% 40%

Exhibit 1.4

Measuring the Risk of Expected Rates of Return

2n

1i

Return) Expected-Return (Possibley)Probabilit(

)( Variance

2iii

1

)]E(R)[RP(

n

i

1.7

Measuring the Risk of Expected Rates of ReturnStandard Deviation is the square

root of the variance

1.8

Measuring the Risk of Expected Rates of Return

Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return

Standard Deviation of ReturnsExpected Rate of Returns

E(R)i

1.9

Measuring the Risk of Historical Rates of Return

variance of the series

holding period yield during period I

expected value of the HPY that is equal to the arithmetic mean of the series

the number of observations

2n

1ii

2 HPY)](EHPY[1

n

n

E(HPY)

HPY

i

2

1.10

Determinants of Required Rates of Return

• Time value of money

• Expected rate of inflation

• Risk involved

The Real Risk Free Rate (RRFR)

–Assumes no inflation.–Assumes no uncertainty about future

cash flows.–Influenced by time preference for

consumption of income and investment opportunities in the economy

Adjusting For InflationReal RFR =

1Inflation) of Rate(1

RFR) Nominal1(

1.12

Nominal Risk-Free Rate

Dependent upon– Conditions in the Capital Markets

– Expected Rate of Inflation

Adjusting For Inflation

Nominal RFR = (1+Real RFR) x (1+Expected Rate of Inflation) -

1

1.11

Facets of Fundamental Risk

• Business risk

• Financial risk

• Liquidity risk

• Exchange rate risk

• Country risk

Risk Premium

f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

orf (Systematic Market Risk)

Risk Premium and Portfolio Theory

• The relevant risk measure for an individual asset is its co-movement with the market portfolio

• Systematic risk relates the variance of the investment to the variance of the market

• Beta measures this systematic risk of an asset

Fundamental Risk versus Systematic Risk

• Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country risk

• Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

Relationship BetweenRisk and Return Exhibit 1.7

Rateof Return

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket LineLow

RiskAverageRisk

HighRisk

The slope indicates therequired return per unit of risk

(Expected)

Changes in the Required Rate of Return Due to Movements Along the SML

Rate

Risk(business risk, etc., or systematic risk-beta)

RFR

SecurityMarket Line

Expected

Movements along the curvethat reflect changes in therisk of the asset

Exhibit 1.8

Changes in the Slope of the SML

RPi = E(Ri) - NRFR

where:

RPi = risk premium for asset i

E(Ri) = the expected return for asset i

NRFR = the nominal return on a risk-free asset

1.13

Market Portfolio RiskThe market risk premium for the market portfolio (contains all the risky assets in the market) can be computed:

RPm = E(Rm)- NRFR where:

RPm = risk premium on the market portfolio

E(Rm) = expected return on the market portfolio

NRFR = expected return on a risk-free asset

1.14

Change in Market Risk Premium

Exhibit 1.10

Risk

RFR

Original SML

New SML

Rm

Rm'

E(R)

NRFR

Expected Return

Rm´

Rm

Capital Market Conditions, Expected Inflation, and the SML

Exhibit 1.11

Risk

RFR

Original SML

New SMLRate of Return

RFR'

NRFR

NRFR´

Expected Return

The InternetInvestments Online

www.financecenter.com

www.investorama.com

www.moneyadvisor.com

www.investorguide.com

www.finweb.com

www.aaii.org

www.wsj.com

www.cob.ohio-state.edu/dept/fin/osudata.htm

www.ft.com

www.fortune.com

www.money.com

www.forbes.com

www.worth.com

www.barrons.com

Future TopicsChapter 2

• The asset allocation decision

• The individual investor life cycle

• Risk tolerance

• Portfolio management